Friday, October 19, 2012

Why diversification doesn't work

You're standing in your canoe, on a beautiful Canadian lake, taking photos of the wildlife, occasionally fishing. Why standing, not sitting? Well, you've read about those disturbing studies that show how sitting is really bad for your long term health; how every hour of television viewing, for example, takes about 20 minutes off your life expectancy, and why the same is probably true for sitting at the computer, sitting reading a book, whatever. So you're standing and that's OK because you're balanced and stable, with your weight distributed uniformly.

Of course, anyone with even a few minutes of experience in a canoe knows this isn't as safe as it seems. What really matters isn't how well-balanced you are when the canoe rests peacefully, but what happens when a few waves come along, kicked up by rednecks passing in a souped-up bass trawler (I lived in rural Virginia for several years, so I know the experience). As you shift your stance to stay upright, and the boat shifts, that balanced distribution vanishes and you can easily tip. Stability demands balance in the midst of the boat's dynamics, not only in the static peace beforehand.

As it turns out, this same lesson applies to investment portfolios -- a new paper in Nature Scientific Reports shows just how important this insight may be.

Famously, of course, Harry Markowitz introduced the idea of diversification into investing back in the 1950s (at least he formalized the idea, which was probably around long before). Using information on the mathematical correlations between the returns of the different stocks in a portfolio, you can choose a weighted portfolio to minimize the overall portfolio of volatility for any expected return. This is maybe the most basic of all results in mathematical finance.

But it doesn't work; it suffers from the same problem as the balanced man in the canoe. This is clear from any number of studies over the past decade which show that the correlations between stocks change when markets move up or down. If the market suddenly plunges downward, you would hope that your well-diversified portfolio, invested as it is in stocks that tend to move unlike one another, would be OK. But when markets move significantly down (or up), it turns out, the correlations are no longer what they were. Trending markets induce strong correlations among stocks that aren't there beforehand, and aren't obvious from long-term averages. So the risks to a portfolio are actually much larger than the simple diversification analysis suggests -- just as the risk of a canoe tipping is much more than it seems to a man standing balanced on a peaceful lake.

The new paper by physicist Tobias Preis and colleagues makes this point with probably the largest data set used so far, looking at the stocks in the DJIA over about 70 years. It's a fairly simple analysis (modulo some nitty gritty details). Roughly, they look at the correlations between different stocks in the DJIA and see how these correlations depend on the recent average return of the DJIA. Are the correlations stable? Or do they go up as the market begins to move? The figure below showing the average correlation coefficient versus the return indicates that the result is clearly the latter: a trending market, in either direction, induces significant correlations among the DJIA stocks.

One of the interesting things here is that this link holds on many different timescales, from 10 days up through two months. The worrying thing for an investor, of course, is that these correlations make the risks of large losses significantly larger than they would appear to be on the basis of long-term correlations alone. As the authors conclude:

... a “diversification breakdown” tends to occur when
stable correlations are most needed for portfolio protection. Our
findings, which are qualitatively consistent with earlier findings42, 44
but quantitatively different, could be used to anticipate changes in
mean correlation of portfolios when financial markets are suffering
significant losses. This would enable a more accurate assessment of the
risk of losses.

409 comments:

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About that graph on correlation increasing for large market fluctuations, I would suspect that the conditioning in itself might be responsible in part for the effect, i.e. even a simulation with fixed correlation amongst assets might induce similar convexity once you condition on large swings. This is tentatively addressed in the paper through shuffling, but I'm not fully convinced. They should either present a detailed computation using a valid model of the local correlation statistics conditioned on the magnitude of swings, or a proper simulation. Maybe it was done, but from a quick read it doesn't seem to be reported in the paper.

This said I believe the result is most likely correct, yet the magnitude of the effect might be somewhat over-stated.

I like this article however investing is not whats driving our economy right now. One of the biggest factors driving the economy today is the current urge to claim back PPI and the refunds awarded by the banks are being spent like lottery winnings!

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Good day! I can clearly see the fact that you deeply get the sense of what you are telling about over here. Do you have an education that is associated with the topic of your blog entry? Can't wait to see your answer.

One of the muse principles of long-run investment is diversification. Diversification implies that rather than investment all or a majority of your investment during a single investment sort or quality category, you portion those funds across totally different forms of investments. The principle is that once you diversify, you guard against experiencing a big decrease in your portfolio price as a result of a selected investment you hold experiences issue.PPI Claims Made Simple

I think that's why we were taught that things aren't always as they seem! Have any of you ever read the Daily Mail's list of things that will give you cancer? Thank god for the common sense he gave us to diversify between actual fact and just plain stupidity!This is a good post, I've always wanted to get into investment, but never had the capital to get started, seems god didn't give me enough common sense!

As the article "A Look at Diversification" stated, "to adequately diversify, it’s important to select securities that have a low correlation — that is, securities that don’t tend to track each other’s movements up and down. Securities with a high correlation may tend to fail together — defeating the purpose of diversification."

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This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

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Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.